The Korean government's latest attempt to create a mega bank is like putting lipstick on a pig. No matter how they dress up the idea, it is still an ugly pig. This time, the government plans to allow KDB Financial Group to take over Woori Finance Holdings, another large bank. The logic behind the idea remains unchanged. The government still equates competitiveness with size.

But wait, they say, as they put a wig on the pig: Having a mega bank as large as the world's top 50 lenders is necessary to give Korean companies a better opportunity to win large overseas contracts (e.g., nuclear power plant construction deals). 

Dangerous idea

It is a misguided idea that banks need to grow much larger in order to enhance competitiveness. The lenders` core competence has nothing to do with size. A big bank can be competitive only in an economy with scale and scope. Otherwise, its large size can lead to bad assets.

Economy of scope can be achieved when the costs for a merged bank to produce two products are lower than the combined costs for two separate banks producing specialized products. This is called the "synergy effect." They can benefit from the economy of scope when the two banks sell different products. 

Against this backdrop, economy of scale may appear if KDB, specializing in wholesale financing, takes over Woori, more experienced in retail financing. But if the two banks have any conflicts of interest, the cost can undercut profit. 

Economy of scale takes place when a bank`s average costs decreases while its size grows.  In theory, average costs tend to fall only to some extent by size. The costs can rise if the bank becomes too large, producing diseconomy of scale. Empirical studies do not always support the economy of scale for the banking sector. Some reports show small banks can benefit from an economy of scale while giants don`t. 

Banking competitiveness comes from transparent ownership, not size

In conclusion, the idea that a merger for size will lead to higher competitiveness can be misleading. It can be even more perilous when integrating two state-owned banks like KDB and Woori. State-controlled banks easily succumb to political pressure, causing inefficiency (e.g., excessive hiring and inappropriate investment). Government support and subsidies can add to inefficiency by shielding banks from the rules of the jungle in the capital market. When merging two banks without addressing problems, they can become weak. If we rely on an incompetent mega bank for large-scale international projects such as nuclear power plants, then costs will be passed on to taxpayers.

A bank can become more efficient and competitive when its ownership is transparent. This fact has been proven in many studies and applies to other industries. One of the major factors helping Samsung Electronics and Hyundai Motor become global powers was their transparent ownership structures. Their success is an outcome of entrepreneurship with the owners channeling available resources into investment and development. To create a bank as competitive as Samsung Electronics or Hyundai Motor, the government should make it clear who owns the banks. A global bank can show the spirit of entrepreneurship in developing new products, management skills, asset management, risk management, and credit controls. 

Privatization should precede merger

The government`s plan to create a global bank by merging KDB with Woori is a mistake. The government should first hand over its control of the two banks to the private sector and let them be run by principles of economics, not by politics if it really wants to nurture a global bank. And the rest should be left in the hands of the banks and the market.

By An, Jaewook, Professor of Economics, Kyung Hee University